Two weeks ago we discussed underpayment of estimated tax – a penalty that is assessed prior to the April 15 due date if you did not pay enough tax in ratably throughout the prior year. Essentially these penalties are the equivalent of the taxing authorities wanting to be paid in installments rather than a lump sum check at the end of the year. (You would be equally upset if your employer only paid you once a year as well!) So they effectively charge you interest (currently a three percent rate) if you do not have enough tax paid in quarterly throughout the year. This week we are going to talk about filing an extension and the penalties and interest that you will incur beginning after April 15 if you do not file and/or pay on time. If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .

The most important piece of advice is to file your return on time! When I say on time, I mean by April 15, or if you file a valid extension, then by October 15. In years where those dates fall on a weekend or holiday, the return due date is pushed to the next business day. There can be hefty penalties for filing a late return, which we will discuss later. Form 4868 is the federal form used to apply for an extension, and you have to postmark it by April 15 for it to be valid. If you are concerned of a postal mishap, U.S. certified mail is the correct way to document it was mailed on time. California gives you an automatic six month extension if you need it, and nothing is required to be filed to receive the extension. (Note there are exceptions regarding extensions for individuals out of the country on April 15, as well as for military people overseas, which we are not discussing in this article.)

Regardless of whether or not you file an extension, the tax is still due on April 15. So you want to be sure you have enough tax paid in to cover the liability when you finally do file the return. This means, you have to do a rough calculation at least, and then send in a check for the estimated tax with the 4868. It would be prudent to estimate on the high side if there is any doubt. If you end up not owing as much as you paid in, you can get a refund when you file the returns, or you can have it applied to the next year’s tax returns, and it will be credited to you as of the original April 15 due date when the first estimated tax payment was also due for the current year taxes (for those that pay quarterly estimates, this is very helpful).

When putting people on extension that pay quarterly estimated taxes, I will typically have them pay the remaining projected balance due from the prior year, plus the first quarter estimate for the current year and have all of this applied as a payment towards the prior year return. This gives them a cushion in case the estimates are wrong. Then, after the returns are filed, any leftover amount is then applied to the current year return and gets credit as of April 15 and everything is fine. If you project you will owe to California, then you will have to fill out a California Form 3519 Payment for Automatic Extension for Individuals and remit a check with that form.

The mechanics of filing the federal Form 4868 are quite simple. On the left side of the form you fill out your name, address, and social security number. On the right side you list your estimate of your total tax liability, the amount you have paid in so far, and then subtract the two to get the estimated amount you are short or over. If you are short, then you write in how much you are planning to pay with the extension. Hopefully you have enough to pay the balance, but if you do not, just pay what you can, and keep making payments when possible. Write your name, social security number, the year for which the tax is due and “Form 4868” on the check as well.

The California Form 3519 Payment for Automatic Extension is quite simple also. You do not even have to list estimates, but just the amount you are paying in addition to your name, address, etc. You would provide similar information on your check to California as well. Federal checks are made out to the “United States Treasury.” California checks are made out to the “Franchise Tax Board.” The mailing addresses are on the forms and related instructions, which can be downloaded online for free. If you are sending in a check for a married filing joint tax return, it is best to put both taxpayer names and social security numbers on the forms AND on the checks.

Now let’s talk about what penalties and interest you will incur if you do not file on time and/or pay on time.

Late Return Penalty

As I mentioned earlier, the most important piece of advice is to file your return on time! A late tax return with the IRS carries a hefty penalty of five percent of the unpaid tax PER MONTH or portion of a month until you file your tax returns. For those of you who aren’t doing the math in your head, that is the equivalent of an annualized interest rate of 60 percent per year (and you thought credit cards were bad!). Fortunately they cap that penalty after five months of delinquency thus maxing it out at 25 percent. Not to be left out, California conforms to this and charges the same for late returns based on the amount of California tax owed.

Late Payment Penalty

Regardless of whether or not you file an extension, if you do not pay the tax by April 15, the IRS will assess you 0.5 percent PER MONTH on the unpaid tax, capping out after 50 months at 25 percent. If the return is also delinquent (no extension filed), the five percent per month late return penalty includes the 0.5 percent per month late payment penalty for the first five months. After the first five months, then you only pay the additional 0.5 percent late payment penalty. So the maximum federal late return and late payment penalty could be 25 percent late return penalty (4.5 percent plus 0.5 percent for five months) plus another 22.5 percent (0.5 percent per month for the next 45 months for the continuing late payment penalty) equals a total of 47.5 percent. California has a slightly different approach on this and immediately charges five percent of the balance if you are even one day late. In addition they assess 0.5 percent PER MONTH or part of a month for the first 40 months, also capping you at 25 percent. So one day late in California will actually cost you 5.5 percent in late payment penalties.

Interest

In addition to the above penalties, interest is also charged starting on April 16 until the taxing authorities get paid in full. Since you had the use of the money and they did not, they want to be paid for their lost use of the funds. The interest rate varies and is adjusted each quarter for the IRS and twice a year for California. The current interest rate is three percent for both the IRS and California. If you had the money sitting in a bank account, you clearly lost out, however, if you had it invested in the markets, you would have probably come out ahead in the past few years. Whereas, you can sometimes get the taxing authorities to waive penalties if you had reasonable cause, interest is virtually impossible to waive. Without the before mentioned penalties, there are many people that would love a three percent loan!

If you have noticed a common thread for the above interest and penalties, it is that they are all based on the amount of tax you were short starting on April 15. If you had paid in more than enough on April 15, there would be no penalties and interest, even if you did not file an extension. Theoretically, you could file several years late and incur no penalties as long as you eventually give them a return showing all the tax had been paid in on time. I do not recommend this practice, however! Eventually you would receive notices and they would even estimate a tax return for you and assess tax, penalties, and interest. Those are usually not in your favor! Also, you never start the statute of limitations running, so you keep yourself open for audit longer.

Most importantly, like me, have fun when you are preparing these forms. If you find all of this interesting, perhaps you should have become an accountant!

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.